Project Economics: Selecting and Prioritizing High Value Projects

Almost all of us have worked on too many projects that have failed because of economic reasons rather than technical reasons. Just as the technical team is required to estimate the effort that will go into a project, a marketing or product management team should estimate the benefits of doing the project. Benefits can come in the form of additional sales, increased customer retention, increased operating efficiencies, and so on.

In this session we look at return on investment (ROI) as well as traditional discounted cash flow methods such as net present value (NPV) and internal rate of return (IRR). We will also look at newer approaches such as economic value added (EVA) and real options valuation, which becomes especially applicable for teams using agile processes or an incremental development process. The math is easy, the concepts are powerful. You will return home with practical knowledge about how to apply these straight-forward techniques to prioritizing and selecting projects.


Transcript

1. Copyright Mountain Goat Software, LLC Project Economics: Selecting and Prioritizing High Value Projects Mike Cohn Mountain Goat Software mike@mountaingoatsoftware.com 1
2. Copyright Mountain Goat Software, LLC Founding member and director of Agile Alliance, Scrum Alliance, and Agile Project Leadership Network Founder of Mountain Goat Software Consultant, author, and speaker Mike Cohn - background 2
3. Copyright Mountain Goat Software, LLC What we want to do 1 2 3 4 1 3 3
4. Copyright Mountain Goat Software, LLC Net Present Value (NPV) Internal Rate of Return (IRR) and ROI Payback Period Modeling Return Prioritizing Non-financial approaches Today’s agenda 4
5. Copyright Mountain Goat Software, LLC Which project would you prefer? $1,000 Project A Investment Return Investment Return Year 0 $1,000 Project B 1 $200 $3,000 2 $300 $500 3 $500 $300 4 $3,000 $200 5
6. Copyright Mountain Goat Software, LLC The time-value of money N A dollar today is worth more than a dollar a year from now I’ll gladly pay you on Tuesday for a hamburger today. 6
7. Copyright Mountain Goat Software, LLC Calculating the value of future dollars To buy a $5 hamburger next Tuesday... To buy a $5 hamburger in a year, how much do I put in the bank today? I would put around $4.99 in the bank today $5.00 1+0.10 $5.00 1.10 $4.54 = = Assumes 10% interest rate The present value of $5.00 a year from now 7
8. Copyright Mountain Goat Software, LLC Present value of one future amount Future Value 1+interest rate Present Value = $5.00 1+0.10 = $4.54 An example: Generalizing FV (1+i)t PV = Simplifying PV = FV(1+i)-t 8
9. Copyright Mountain Goat Software, LLC Net present value (NPV) N ,96
   AC6D6?E
   G2=F6
   @7
   2
   DEC62>
   @7
   42D9
   S@HD N Measures the return on a theme or project as an amount of money Ft(1+i)-t NPV(i) = ∑ t=0 n 9
10. Copyright Mountain Goat Software, LLC NPV example N Assuming 12% annual discount rate (3% / quarter) Quarter Cash flow (1+i)-t Discounted Cash Flow Running Total 0 -200 1.000 -200 -200 1 -600 0.971 -583 -783 2 100 0.943 94 -689 3 300 0.915 275 -414 4 500 0.888 444 30 10
11. Copyright Mountain Goat Software, LLC Discount rate sensitivity N NPV is highly sensitive to the chosen discount rate Quarter Cash flow Discounted Cash Flow (3%) Discounted Cash Flow (6%) 0 -200 -200 -200 1 -600 -583 -783 2 100 94 -689 3 300 275 -414 4 500 444 30 Total 100 30 -29 Do the project under these conditions But not under these 11
12. Copyright Mountain Goat Software, LLC Comparing NPVs N Highest NPV brings the most present-value dollars to the company Theme NPV Scalability Gift registry Ad hoc reporting Pay by invoice $2,100 $1,253 $784 $385 Comparing NPVs can be misleading. What if: N “Pay by invoice” requires a $5 investment N “Scalability” requires $50,000? 12
13. Copyright Mountain Goat Software, LLC Net Present Value (NPV) Internal Rate of Return (IRR) and ROI Payback Period Modeling Return Prioritizing Non-financial approaches Today’s agenda 13
14. Copyright Mountain Goat Software, LLC Return as a percentage N Rather than expressing returns in dollars, we’d like to express return as a percentage N Allows for direct comparisons N NPV = how much money a project will return N ROI = how quickly an investment will grow 14
15. Copyright Mountain Goat Software, LLC Internal rate of return (IRR) and ROI N IRR = Internal Rate of Return N Often called Return On Investment (ROI) N The interest rate at which NPV is 0 0 = PV(i*) = F t 1+ i ( )−t t= 0 n ∑ 15
16. Copyright Mountain Goat Software, LLC Remember this table? NIRR gives us the discount rate at which we don’t care whether or not we do the project NWe don’t make $30; we don’t lose $29; we break even Quarter Cash flow Discounted Cash Flow (3%) Discounted Cash Flow (6%) 0 -200 -200 -200 1 -600 -583 -783 2 100 94 -689 3 300 275 -414 4 500 444 30 Total 100 30 -29 16
17. Copyright Mountain Goat Software, LLC How to calculate ROI or IRR N Use Excel’s irr function +irr({−200, −600, 100, 300, 500}) An investment >256
    @?
    E96
    RCDE
    day of the project 2D9
    S@HD
    7@C
    remainder of project (4 quarters) 17
18. Copyright Mountain Goat Software, LLC Advantages and disadvantages N Advantages N You don’t need to guess at a discount rate like with NPV N Can be used to directly compare projects N Disadvantages N Calculation is hard to do by hand (but easy in Excel); may lead to numbers being distrusted N Cannot use in all circumstances N 6 8 
    @?46
    42D9
    S@H
    EFC?D
    A@D:E:G6
    :E
    DE2JD
    A@D:E:G6 18
19. Copyright Mountain Goat Software, LLC Net Present Value (NPV) Internal Rate of Return (IRR) and ROI Payback Period Modeling Return Prioritizing Non-financial approaches Today’s agenda 19
20. Copyright Mountain Goat Software, LLC Quarter Cash Flow Running Total 0 1 2 3 4 -200 -200 -200 -400 100 -300 300 0 500 500 Payback period N The amount of time before an initial investment is paid back N I loan you $5. You pay me back $1/week. The payback period is 5 weeks. Payback period is 3 quarters. 20
21. Copyright Mountain Goat Software, LLC Advantages and disadvantages N Advantages N Calculation is very easy N %62DFC6D
    E96
    5FC2E:@?
    @7
    R?2?4:2=
    C:D< N Longer payback period = greater risk N Disadvantages N Doesn’t consider the time-value of money N @6D?PE
    >62DFC6
    AC@RE23:=:EJ
    2E
    2== 21
22. Copyright Mountain Goat Software, LLC Discounted payback period N :D4@F?E
    7FEFC6
    42D9
    S@HD
    2?5
    56E6C>:?6
    when the investment is paid back Discounted payback period = 4 quarters Quarter Cash Flow (1+i)-t i=3% Discounted Cash Flow Running Total 0 -200 1.000 -200 -200 1 -200 0.971 -194 -394 2 100 0.943 94 -300 3 300 0.915 275 -25 4 500 0.888 444 419 22
23. Copyright Mountain Goat Software, LLC Financial analysis recap NNet Present Value (NPV) N+F>
    @7
    5:D4@F?E65
    7FEFC6
    42D9
    S@HD NExpresses return as an amount of money NReturn on Investment (ROI) / Internal Rate of Return NThe interest rate at which NPV = 0 N That is, at which you’d be indifferent to the investment NExpresses return as a percentage NDiscounted payback period NAmount of time before discounted returns equal the investment NExpresses return as an amount of time 23
24. Copyright Mountain Goat Software, LLC Net Present Value (NPV) Internal Rate of Return (IRR) and ROI Payback Period Modeling Return Prioritizing Non-financial approaches Today’s agenda 24
25. Copyright Mountain Goat Software, LLC You need a business model N These formulas assume you have a model of the returns a project or theme will generate Business model C urrent custom ers Future custom ers C om petition M arket acceptance Period 1 Period 2 Period 3 25
26. Copyright Mountain Goat Software, LLC A relatively simple way to model N Consider your revenue sources and group them N These four often work well: 1. New revenue 2. Incremental revenue 3. Retained revenue 4. 'A6C2E:@?
    67R4:6?4J 26
27. Copyright Mountain Goat Software, LLC New revenue N Money we’ll make selling products or services to new customers N ,96
    RCDE
    E9:?8
    >@DE
    A6@A=6
    E9:?<
    @7
    H96?
    E96J
    think of the return on a project NIn addition to selling books, Amazon decides to sell music CDs. 27
28. Copyright Mountain Goat Software, LLC Incremental revenue N Sometimes worth distinguishing from new revenue N Typically comes because new product or service: N Encourages existing customers to buy or license more N Includes optional, add-on modules that are sold separately N Includes features that justify a higher price N Encourages use of consulting services NAn eCommerce site decides to offer gift wrapping for $5 per box. 28
29. Copyright Mountain Goat Software, LLC Retained revenue N Revenue you’ll lose if the project is not performed N Revenue you’ll lose is different from revenue you won’t get N Customers who will stay with you who otherwise would leave NWe’re losing customers because our eCommerce site doesn’t offer gift wrapping. NOur competitors have added features we don’t have 29
30. Copyright Mountain Goat Software, LLC 'A6C2E:@?2=
    67R4:6?4J N Most applicable for internally used software N But also a factor on commercial products N Anything that takes a long time N Or will take a long time as the company grows N Anything that improves accuracy or reduces rework N An eCommerce site with third-party sellers. It takes 2 hours of manual time to add each seller. N Our commercial software has usability issues, we get a lot of tech support calls. N We spend 16 hours training new employees how to use our internal software 30
31. Copyright Mountain Goat Software, LLC An example: WebPayroll N Offers web-based payroll system to small companies N Calculates payroll taxes, prints checks, etc. N We tell customers they need to enter payroll data 3 days before they want checks N Our goal: Next-day service N Enter data by 5pm, we print checks and overnight them to the company 31
32. Copyright Mountain Goat Software, LLC Facts about WebPayroll N Average customer – pays $400/year in fees N Overnight delivery will appeal to smaller customers, paying an average of $200/year N We think we’ll make another $100/year per customer that uses the over night service N Average new customer is then worth $300/ year ($200+$100), or $75/quarter N New feature will take four months to deliver 32
33. Copyright Mountain Goat Software, LLC WebPayroll: new revenue N Sales says 50 new customers/quarter this year; 100 next year Quarter New Customers Revenue per Customer New Revenue 1 2 3 4 5 6 7 8 0 $0 $0 50 $50 $2,500 50 $75 $3,750 50 $75 $3,750 100 $75 $7,500 100 $75 $7,500 100 $75 $7,500 100 $75 $7,500 33
34. Copyright Mountain Goat Software, LLC WebPayroll: incremental revenue N We estimate we’ll sign up 100 existing members per quarter until we have 400 Quarter Customers Revenue per Customer Incremental Revenue 1 2 3 4 5 6 7 8 0 $0 $0 100 $16 $1,600 200 $25 $5,000 300 $25 $7,500 400 $25 $7,500 400 $25 $10,000 400 $25 $10,000 400 $25 $10,000 34
35. Copyright Mountain Goat Software, LLC WebPayroll: retained revenue N Sales say we’ll retain 10 customers per quarter Quarter Retained Customers Total Retained Revenue per Customer Retained Revenue 1 2 3 4 5 6 7 8 10 10 $100 $1,000 10 20 $100 $2,000 10 30 $100 $3,000 10 40 $100 $4,000 10 50 $100 $5,000 10 60 $100 $6,000 10 70 $100 $7,000 10 80 $100 $8,000 35
36. Copyright Mountain Goat Software, LLC 'A6C2E:@?2=
    67R4:6?4J N We can avoid hiring a new payroll clerk a year from now at a fully burdened labor cost of $30,000/year. Quarter Payroll Clerks Not Needed Fully Burdened Labor Cost Operational 7R4:6?4:6D 1 2 3 4 5 6 7 8 0 $0 $0 0 $0 $0 0 $0 $0 0 $0 $0 1 $7,500 $7,500 1 $7,500 $7,500 1 $7,500 $7,500 1 $7,500 $7,500 36
37. Copyright Mountain Goat Software, LLC All the numbers for WebPayroll Q Dev Cost New Revenue Incr. Revenue Retained Revenue Oper. 7R4:6?4:6D Net Cash Flow 1 2 3 4 5 6 7 8 −$90,000 $0 $0 $1,000 $0 −$89,000 −$30,000 $2,500 $1,600 $2,000 $0 −$23,900 $3,750 $5,000 $3,000 $0 $11,750 $3,750 $7,500 $4,000 $0 $15,250 $7,500 $7,500 $5,000 $7,500 $27,500 $7,500 $10,000 $6,000 $7,500 $31,000 $7,500 $10,000 $7,000 $7,500 $32,000 $7,500 $10,000 $8,000 $7,500 $33,000 37
38. Copyright Mountain Goat Software, LLC WebPayroll - NPV Quarter Net Cash Flow (1+i)-t Present Value 1 2 3 4 5 6 7 8 −$89,000 0.971 −$86,419 −$23,900 0.943 −$22,538 $11,750 0.915 $10,751 $15,250 0.888 $13,542 $27,500 0.863 $23,733 $31,000 0.837 $25,947 $32,000 0.813 $26,016 $33,000 0.789 $26,037 NPV (12%) = $43,106 38
39. Copyright Mountain Goat Software, LLC WebPayroll - ROI +irr(A1:A9, .10) A 1 2 3 4 5 6 7 8 9 0 −$89,000 −$23,900 $11,750 $15,250 $27,500 $31,000 $32,000 $33,000 6% 39
40. Copyright Mountain Goat Software, LLC WebPayroll - Payback Period Quarter Net Cash Flow Running Total 1 2 3 4 5 6 7 8 −$89,000 −$89,000 −$23,900 −$112,900 $11,750 −$101,150 $15,250 −$85,900 $27,500 −$58,400 $31,000 −$27,400 $32,000 $4,600 $33,000 $37,600 Payback period = 7 quarters 40
41. Copyright Mountain Goat Software, LLC WebPayroll - Discounted Payback Period Quarter Net Cash Flow (1+i)-t 3% Present Value Running Total 1 2 3 4 5 6 7 8 −$89,000 0.971 −$86,419 −$86,419 −$23,900 0.943 −$22,538 −$108,957 $11,750 0.915 $10,751 −$98,206 $15,250 0.888 $13,542 −$84,664 $27,500 0.863 $23,733 −$60,931 $31,000 0.837 $25,947 −$34,984 $32,000 0.813 $26,016 −$8,968 $33,000 0.789 $26,037 $17,069 Discounted payback period = 8 quarters 41
42. Copyright Mountain Goat Software, LLC Net Present Value (NPV) Internal Rate of Return (IRR) and ROI Payback Period Modeling Return Prioritizing Non-financial approaches Today’s agenda 42
43. Copyright Mountain Goat Software, LLC You need to know the cost N To prioritize you must know the cost N If you had no idea of the costs, which car would you be inclined to buy? N Estimate the development time of each project N Person-weeks, story points, ideal days N Calculate your cost per that unit N $4,500 per person-week N $3,100 per story point 43
44. Copyright Mountain Goat Software, LLC Calculating cost per person-week Development budget last year $2,100,000 Person weeks worked 6x52+1x39=351 Cost per week $2.1M / 351 = $5,982 So, if a project is estimated at 25 person- weeks: - 25 x $6000 = $150,000 44
45. Copyright Mountain Goat Software, LLC Using story points Development budget last year $2,100,000 ,@E2=
    DE@CJ
    A@:?ED
    R?:D965
    =2DE
    J62C 343 Cost per story point $2.1M / 343 = $6,122 So, if a project is estimated at 25 story points: - 25 x $6000 = $152,500 45
46. Copyright Mountain Goat Software, LLC Theme (project) comparison matrix Person Weeks Cost 3-Year Return NPV IRR D. Payback (Quarters) Theme A Theme B Theme C Theme D Theme E Theme F Theme G Theme H Theme I Theme J Theme K Theme L Theme M Theme N Theme O Theme P 25 $150 $1,085 $448 133% 2 32 192 $2,109 $940 172% 4 90 $540 $2,537 $883 89% 2 48 $288 $1,360 $443 76% 4 55 $330 $900 $191 48% 2 79 $474 $1,365 $331 56% 4 90 $540 $5,964 $2,519 139% 5 50 $300 $2,415 $1,023 146% 2 15 90 $1,600 $747 221% 1 30 $180 $640 $182 65% 2 75 $450 $516 ($104) 5% NA 40 $240 $171 ($110) (12%) NA 80 $480 $1,025 $142 36% 3 18 $108 $185 $7 24% 2 6 36 $155 $53 90% 1 12 $72 $1,505 $748 355% 1 46
47. Copyright Mountain Goat Software, LLC What do you select? It’s March 18 and you are meeting to plan the April-June quarter. Your team now has 7 people. That’s 7*13=91 person-weeks in a quarter. What do you select? 47
48. Copyright Mountain Goat Software, LLC Theme (project) comparison matrix Person Weeks Cost 3-Year Return NPV IRR D. Payback (Quarters) Theme A Theme B Theme C Theme D Theme E Theme F Theme G Theme H Theme I Theme J Theme K Theme L Theme M Theme N Theme O Theme P 25 $150 $1,085 $448 133% 2 32 192 $2,109 $940 172% 4 90 $540 $2,537 $883 89% 2 48 $288 $1,360 $443 76% 4 55 $330 $900 $191 48% 2 79 $474 $1,365 $331 56% 4 90 $540 $5,964 $2,519 139% 5 50 $300 $2,415 $1,023 146% 2 15 90 $1,600 $747 221% 1 30 $180 $640 $182 65% 2 75 $450 $516 ($104) 5% NA 40 $240 $171 ($110) (12%) NA 80 $480 $1,025 $142 36% 3 18 $108 $185 $7 24% 2 6 36 $155 $53 90% 1 12 $72 $1,505 $748 355% 1 48
49. Copyright Mountain Goat Software, LLC Net Present Value (NPV) Internal Rate of Return (IRR) and ROI Payback Period Modeling Return Prioritizing Non-financial approaches Today’s agenda 49
50. Copyright Mountain Goat Software, LLC Kano analysis Linear The more of it, the better Three types of features Exciters / Delighters Features a user doesn’t know she wants, until she sees it Mandatory / Baseline Must be present in order for FD6CD
    E@
    36
    D2E:DR65 50
51. Copyright Mountain Goat Software, LLC Surveying users N To assess whether a feature is baseline, linear, or exciting we can: N Sometimes guess N Or survey a small set of users (20-30) N We ask two questions N A functional question N How do you feel if a feature is present? N And a dysfunctional question N How do you feel if that feature is absent? 51
52. Copyright Mountain Goat Software, LLC Functional and dysfunctional forms Functional form of question If your hotel room includes a free bottle of water, how do you feel? I expect it to be that way. I like it that way. I am neutral. I can live with it that way. I dislike it that way. X Dysfunctional form of If your hotel room does not include a free bottle of water, how do you feel? I expect it to be that way. I like it that way. I am neutral. I can live with it that way. I dislike it that way. X 52
53. Copyright Mountain Goat Software, LLC Categorizing an answer pair Q E E E L R I I I M R I I I M R I I I M R R R R Q Like Expect Neutral Live with Dislike Like Expect Neutral Live with Dislike Dysfunctional Question Functional Question M Mandatory L Linear E Exciter Q Questionable R Reverse I Indifferent 53
54. Copyright Mountain Goat Software, LLC Aggregating results 3 11 31 1 3 2 4 22 20 4 1 0 21 9 14 5 1 1 Apply formatting themes Automate report execution Export reports to PowerPoint Questionable Reverse Indifferent Mandatory Linear Exciter Theme 54
55. Copyright Mountain Goat Software, LLC What to include NAll of the baseline features NJ
    56R?:E:@?
    E96D6
    >FDE
    36
    AC6D6?E NSome amount of linear features NBut leaving room for at least a few exciters 55
56. Copyright Mountain Goat Software, LLC Relative weighting N Assess the impact of having a story/theme from 1-9 N Assess impact of NOT having it from 1-9 N Calculate the value of each story or theme relative to the entire product backlog N This gives you the relative value of that story or theme N Estimate the cost of each story theme N Calculate the cost of each story or theme relative to the entire product backlog N This gives the relative cost of that story or theme N Priority is given by (Relative Value ÷ Relative Cost) 56
57. Copyright Mountain Goat Software, LLC Relative weighting: an example ,@E2=
    .2=F6
    
    *6=2E:G6
    6?6RE
    
    *6=2E:G6
    (6?2=EJ Value Percent = Total Value / ∑ (Total Value) Cost Percent = Estimate / ∑ (Estimate) 8 6 14 40 64 44 More investment choices Portfolio rebalancing Comply with new law Cost Percent Estimate Value Percent Total Value Relative Penalty *6=2E:G6
    6?6RE 91 Priority Total 9 2 11 31 40 27 115 1 9 10 29 42 29 100 35 100 146 100 Themes 57
58. Copyright Mountain Goat Software, LLC An example with weights 8 6 22 41 64 44 More investment choices Portfolio rebalancing Comply with new law Cost Percent Estimate Value Percent Total Value Relative Penalty *6=2E:G6
    6?6RE Themes 93 Priority Total 9 2 20 38 40 27 141 1 9 11 21 42 29 72 53 10 14 10 2 1 Weight→ 58
59. Copyright Mountain Goat Software, LLC mike@mountaingoatsoftware.com www.mountaingoatsoftware.com (720) 890-6110 (office) (303) 810-2190 (mobile) Mike Cohn contact info 59